Value at risk

Value at risk

Value at Risk (VaR), a statistic used to forecast the biggest potential losses over a certain period, has been termed the “new science of risk management.” It is a well-known and widely used risk assessment method. The VaR model estimates the downside risk of a portfolio and helps investors make informed decisions while managing their risk exposure.  

What is value at risk (VaR)? 

Value at risk, commonly known as VaR, is a statistical tool used to measure the potential loss an investment portfolio may incur over a specific period. VaR is a risk management technique that helps investors estimate the maximum loss they could face in normal market conditions. It is a widely used tool in the financial industry to manage and control risk exposure, especially in the field of investment banking, asset management, and trading. 

Understanding value at risk (VaR) 

VaR works by analysing the statistical properties of a financial portfolio and estimating the probability of losses beyond a certain threshold. The VaR calculation is based on the historical price movements of the underlying assets and the correlation between them. The VaR value represents the maximum loss the portfolio is expected to incur over a specific period with a given confidence level. 

For example, if a portfolio has a VaR of US$100,000 at the 97% confidence level, there is a 3% chance that the portfolio could lose more than US$100,000 over a defined period. Investors can use this information to set risk limits, allocate capital, and make informed decisions about their investment strategies. 

VaR is a powerful tool that helps investors understand and manage their investments’ risk. While it has some limitations, such as its dependence on historical data and the assumption of normal market conditions, it remains an essential tool for financial risk management. By using VaR, investors can make informed portfolio decisions and optimise their risk-return trade-offs. 

Advantages of value at risk (VaR) 

Using VaR in managing risk has several benefits, including: 

• You can compare VaR calculations across many asset classes, including currencies, bonds, derivatives, shares, or portfolios. 
• It is a singular figure that can be easily understood and is frequently used by experts in the financial sector. It can be stated in price units or as a percentage. 
• Due to its prominence, VaR is frequently calculated and included for you in different financial software tools, like a Bloomberg terminal. 

Disadvantages of value at risk (VaR) 

VaR is frequently criticised for providing a misleading sense of security since it under-reports the highest possible loss. One of its drawbacks is that the statistically most probable outcome isn’t necessarily the actual event. 

Furthermore, no standardised method for the statistics is used to assess portfolio, firm-wide, or asset risk. For instance, statistics taken randomly from a time of low volatility may underestimate the likelihood and severity of risk occurrences. Using normally distributed probabilities, which seldom consider extraordinary or “black swan” events, might further underestimate risk. 

The fact that the estimate of possible loss indicates the result with the lowest risk is another drawback of Value at Risk. An expectation of losing at least 20% on average once every 20 days, for instance, is represented by a VaR determination of 95% with 20% asset risk. According to this computation, a 50% loss still supports the risk assessment. 

Value at risk (VaR) example 

For example, an investment manager may use VaR to estimate the maximum potential loss over the next day or week with a 95% confidence level. 

To calculate VaR, one must first gather historical data on the investment or portfolio in question, such as prices, returns, and volatility. This data is then used to construct a statistical model, such as a normal distribution or Monte Carlo simulation, to estimate the likelihood of future losses.  

The VaR calculation typically involves determining the potential loss at a certain confidence level, such as 95%, over a specific time horizon, such as one day or one week. 

VaR may be calculated in a many ways, but the historical technique is the most simple: 

VaR = vm (vi / v(i – 1)). 

The number of days used to calculate historical data is M. 

The number of variables on day i is vi. 

The formula’s goal is to calculate each risk factor’s per cent change over the previous 252 trading days. The future value of the security is then calculated for 252 possibilities by applying each per cent change to the security’s existing market values. 

Frequently Asked Questions